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Research Note

April 2020

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Copyright © 2020 Morpho Advisory Limited. All rights reserved.

Research Note

April 2020

CONTENTS

1. It’s always been about risk

2. Risk-based strategies in action

3. Quantify that risk

4. And now for the News

5. It pays to tinker

6. We’ve been doing a spot of quanting

Welcome to our April 2020 Research Note. In this document we express our strategic view on the implications of what a

world of zero percent interest rates means for investing. In light of this situation, we question and challenge the orthodox

approach to investing used by the vast majority of asset management firms and pension funds the world over. Then we go

on to demonstrate the alternative approach to investing that we have developed. We also turn our attention to the

problem of risk – defining it; measuring it; and avoiding unnecessary incidents. Lastly, we take a look at what we’ve been

doing, thinking and saying over the past year, concluding with a sneak peek of what of what we are currently working on.

We hope you enjoy reading this Research Note. If not enjoyable, we do at least, hope it gets you thinking.

1. It’s always been about risk

For 40 years now, investing in financial assets has been easy. Oh, we acknowledge there have been bumps along the way,

a couple of which have even been sizeable, but in general it has been like riding a bicycle downhill on a sunny day - and

having the wind at your back. Asset managers have been able to adopt simplistic approaches to building investment

portfolios such as investing in a portfolio that consists of 60% equities and 40%

bonds. This was because the academic theory said that when equities fall, bonds

will deliver gains and vice versa. Then it was just a matter of sitting back and

letting the good returns roll in, seemingly in spite of the manager’s attempt to

add value, as few managers have been able to outperform passive investment

strategies. Yes indeed, the last 40 years has seen a rising tide lift all boats.

Fig. 1.1 illustrates how the since the early 1980s the global decline in interest rates has been a contributing factor in the performance of equity markets (here

shown on an inverted log scale). Over the medium-term during that period the movement of these two asset classes has been largely uncorrelated, supporting the

notion of so called “60-40” funds as a means of mitigating market risk in an investment portfolio. With global interest rates now nearing zero (if not lower), the

ability of bonds to offset equity market risk in any meaningful way is now eradicated. Asset management professionals need to prove their worth going forward.

The last 40 years has seen a rising tide lifts all boats

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Research Note

April 2020

This summary may seem scathing, but it is closer to the truth than many asset managers would care to admit. Every asset

manager has undoubtedly worked hard in their role as fiduciary of other people’s money. However, we would question

whether they have worked smart, despite the fact it is any industry populated with academically smart people. We question

whether they started at the right place? For the most part, asset managers started from the academic theory mentioned

above. Namely, a mix of equities and bonds as the core of their portfolio. It was unquestioned – that’s just how you invest,

it’s how everyone does it. Isn’t it? Then you try to beat the market and peers by way of market timing and security selection.

Morpho Advisory (“Morpho”) was started because we came to the realisation that this approach to investing is

fundamentally flawed. The asset management industry have looked at historic returns and expect these to continue into

the future – despite their “past results…” disclaimer, and have built their portfolios accordingly. We are firmly of the view

that investing starts, not with chasing returns, but with identifying risk. What are the risks – and by this we mean real world

risk (i.e. of losing money) not academic risk (i.e. volatility as measured by standard

deviation). Where are the risks? If you can’t identify risks then you can’t perform

risk management. This is where the asset management industry falls down. They

attempt to identify risk using the same bottom-up approach that shapes the silos

they use in their portfolio management: risk in individual securities; risk in sectors;

and risk in asset classes. By doing so they ignore both systematic risks and structural

risks within the construction of their portfolios, which risks must be carried by the

investing public they serve. To this, asset managers would claim that diversification

is their approach to risk management – holding a bit of every security in every

market based on market capitalisation. But, as we pointed out in our April 2019

Research Note, global markets are more correlated than many are aware of and

this superficial form of diversification offers little in the way of risk protection.

Starting from the point of addressing risk

at the highest level is Morpho’s approach,

as we detailed in our Research Note of April 2019. Successfully being able to

identify risk, by its very nature, should guide portfolio design & construction,

which goes on to define asset allocation, followed by market timing and finally

security selection. All of these aspects working to address the problem of risk.

Done properly, superior long-term returns are an out-working. And this is where

the asset management industry faces its primary flaw and must acknowledge

they have no ‘edge’. They would say, “If we can’t take risk then we can’t make

money”, and there is a long history of alternative investment strategies

demonstrating just that. However, it’s not about taking no risk, it’s about building

asymmetry of risks into investment strategies, processes and portfolios to

capture significantly more upside return than downside - and that is where skill is

required. The asset management industry is populated with academically

intelligent people.

Now is the time for those people to step forward, because the

easy days of making healthy returns are over. The people on

whose behalf they act as fiduciaries require them to show

expertise – not just of the academic variety, but through real

world application.

Given Morpho’s risk-based approach to investing, it was natural

that we foresaw the day approaching when global interest rates

would be at zero whilst bond duration simultaneously

Risk Management

Portfolio Construction

Asset Allocation

Market Timing

Asset Selection

Successfully being able to identify risk, by its very nature, should

guide portfolio design & construction, which

goes on to define asset allocation followed by market timing and

finally security selection

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Research Note

April 2020

lengthens, resulting in no yield but an increase in volatility

from the supposedly defensive component of a portfolio.

Additionally, in the chase for yield, there will be an increase in

exposure to credit, whose price behaviour is already highly

correlated to equities. What becomes of a “60-40” portfolio

when the 40% is doing little or nothing? While some in the

industry have been aware of this potentiality, few have looked

to alter their approach to investing. By comparison, we at

Morpho, in anticipation of this eventuality, have already

developed (and continue to do so) alternative uncorrelated

strategies that do not place the same reliance on bonds being

the primary mitigant to risky assets in an investment portfolio.

Strategies which also act to improve long-term returns whilst

reducing drawdown and volatility risks relative to major

market indices.

2. Risk-based strategies in action

In our Research Note of April 2019 we described our risk-based approach to investing by way of applying it as an asset

allocation methodology that challenges the orthodox approach. Toward the end of that document we went on to show

how our approach naturally lent itself to be applied further out along the risk spectrum, demonstrating an increasing

degree of benefit. Unsurprisingly, as little as one month after we published that research, we had evolved our proprietary

systematic risk-based methodology from being a superior tactical asset allocation process into a range of absolute return

strategies. We stress that none of these strategies have been historically optimized or ‘tweaked’. We simply transplanted

the same low-frequency insight-based process we

wrote about in April 2019 and applied it to absolute

return strategies.

The following series of charts illustrate the

performance of our three primary absolute return

strategies (after fees) relative to major market

indices. The charts compare our strategies relative

to market on the basis of: Total Return; Drawdowns,

Volatility of returns; and Asymmetry (i.e. greater

upside than downside, especially relative to the

standard deviation of returns).

Fig. 2.1 (right) illustrates our U.S. absolute return strategy, comparing

it to the S&P 500 Index. This strategy uses a mixture of assets and asset

classes at various points in the market cycle. One of these components

is exposure to the S&P 500 via the SPDR SPY ETF, which is why we

call it our U.S. strategy. Also included are commodities and bonds.

But as we mentioned above, we are continuing to develop our

strategies to reduce reliance on bonds going forward.

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Research Note

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Being curious, we decided to investigate the efficacy of our Uncorrelated Alpha strategy over the longest period we could.

We were able to apply it to 60 years of data. We reiterate the point we made in our April 2019 Research Note, that we only

ran market data through our model after it was complete. This is an insight-based model, not a historically optimized model

that engaged in any form of “curve fitting”. The results of our historic analysis is demonstrated in the following charts.

Please note, no allowance

was made for the deduction

of fees from Morpho’s

Uncorrelated Alpha returns

for this analysis.

Fig. 2.4 (right) illustrates Morpho’s

Uncorrelated Alpha absolute return

strategy over 60 years, since 1959. It

shows Total Return and Drawdowns for

the strategy and compares them to those

of the S&P 500 over the same period.

On a simple comparison basis, the Total

Return of the strategy is superior to the

S&P 500 but at the expense of a history

of larger Drawdowns & higher

Volatility than that of the S&P 500.

Fig. 2.2 (right) illustrates our Emerging Markets absolute

return strategy, comparing it to the MSCI EM Index. This

strategy is similar to our U.S. strategy but replaces S&P 500

with exposure to EM via the iShares EEM ETF, which is

why we call it our EM strategy, plus it has exposure to

additional commodities.

The Total Return and Drawdown profile of Morpho’s

strategies illustrated in Fig. 2.1 & 2.2 are vastly superior to

that of their respective market indices, as is the standard

deviation of returns.

However, the asymmetry of returns is what we are most

proud of. Side-by-side comparison of our strategy with

market indices illustrates Morpho’s superior upside capture,

whilst market indices demonstrate the opposite. This is

especially noticeable when rolling 3 year returns are

compared to the rolling 3 year standard deviation of returns

for each.

Fig. 2.3 (right) illustrates our Uncorrelated Alpha absolute

return strategy, comparing it to both the S&P 500 Index and

the MSCI Emerging Markets Index. This strategy is a purely

commodity based strategy.

This strategy demonstrates the highest Total Return of our

three core absolute return strategies. It also demonstrates

higher Drawdowns than our other strategies (although still

below those of both the S&P 500 and MSCI EM Index) but

with higher standard deviation of returns than market indices

– which poses the question: “How do YOU define risk?”

The real strength of this strategy is that it is uncorrelated to

major markets, making it yield-enhancing & risk-reducing at

a portfolio level.

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Research Note

April 2020

3. Quantify that risk

When we developed our insight-based and risk-focused approach to investing, we knew we were onto a good thing. Then,

once we applied these insights to absolute returns strategies, it was validated by market data. Yet, we were left with a

dilemma. We could clearly see that Returns were higher and Drawdowns lower when investing via our absolute return

strategies compared to the broader market. But, we work in an industry that has a suite of abstract and academic concepts

and measures used to test various investments on the basis of return relative to risk. There are so many of these formulas

that few managers use the same metrics, except for one particular measure that all asset managers use even when they

are a disparaging of it, being aware of its limitations. That measure is the Sharpe Ratio, developed in 1966.

We knew the underlying attributes of our strategies should make it compare favourably on a risk-adjusted basis relative to

broad market exposures. But when we applied the Sharpe Ratio to the return series the results were OK, but not as good

as they should have been. We had encountered the primary flaw in the

Sharpe Ratio – something few people achieve. The Sharpe Ratio only works

when the underlying returns display a normal distribution. Our absolute

strategies generate returns that do not have a normal distribution. On the

contrary, the returns of our strategies are positively skewed and display a

greater portion of fat tails to the upside. So we set out to make the Sharpe

Ratio more meaningful to our strategies, but also more useful for broader

Fig. 2.5 (right) illustrates the

correlation of Morpho’s

Uncorrelated Alpha strategy to the

S&P 500 over 60 years.

A rolling 3 year Beta of Morpho’s

strategy relative to the S&P 500

shows a consistent lack of

correlation over 60 years.

Calculating Jensen’s Alpha on a

rolling 3 years basis using the S&P

500’s Beta shows significant &

positively skewed investment

alpha generated over 60 years.

Fig. 2.6 (right) illustrates the

benefits of truly diversified

investments at a portfolio level.

Combining equal exposures to

Morpho’s strategy and the S&P

500 results in…

(i) 60 years of Annualized Returns

that are almost double;

(ii) a halving of the Maximum

Drawdown (with significantly

lower cyclical Drawdowns over

the 60 years); and

(iii) a reduction in annualized

Volatility

…compared to a standalone

investment in the S&P 500.

Our absolute strategies generate returns that do not have a normal distribution

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Research Note

April 2020

application. In the end, we developed two methods of adjustment to the Sharpe Ratio that allow for both normal and non-

normal distributions, and that illustrate the difference in risk-adjusted returns of our strategies compared to those of the

broad market. Essentially they are the same solution, but when applied both to our strategy returns and market returns,

one results in our ‘modified’ Sharpe Ratio being materially unchanged from the standard Sharpe Ratio whilst the market’s

modified Sharpe Ratio is reduced. The other results in the market’s modified Sharpe ratio remaining unchanged from the

standard Sharpe Ratio while that of our strategies in increased. We preferred the latter option as it generates numbers

that are meaningful to investment professionals who are familiar with the Sharpe Ratio. We named our modification the

“Morpho Ratio”, which is really just an adjustment factor applied to the existing Sharpe Ratio formula, so perhaps the

“Morpho Adjustment Factor” might be a better description.

We had no idea when we started on this journey that we would end up

fixing one of the oldest and most respected formulas in investing – just as

a side project because its weakness annoyed us. Many academics have attempted to improve on the Sharpe Ratio, but in

our research of those attempts we found them wanting, so we did it ourselves. In the process, we discovered a statistical

approach to identify & quantify potential investment risk that reflects the real world, unlike academic normal distribution

based approaches used across a range of financial risk management disciplines (e.g. VaR). A handy tool to have.

The following series of charts show a side-by-side comparison of the Sharpe Ratio of our absolute strategies next to those

of market indices. Each chart compares the standard Sharpe Ratio to our Morpho Ratio, which more accurately reflects

the underlying distribution of returns in the data set.

Fig. 3.3 (above left) shows the rolling 3 year Sharpe Ratio for Morpho’s E.M. strategy, comparing the standard Sharpe Ratio with the Morpho Ratio.

Fig. 3.4 (above right) shows the rolling 3 year Sharpe & Morpho Ratios for the MSCI EM Index. MSCI EM’s Sharpe Ratio is unchanged, due to its normal distribution.

Fig. 3.1 (above left) illustrates the rolling 3 year Sharpe Ratio for Morpho’s U.S. strategy, comparing the standard Sharpe Ratio formula with the Morpho Ratio (the

Sharpe Ratio adjusted to reflect the true distribution of returns rather than presuming a normal distribution). Notice how this adjustment improves on what is already

a healthy Sharpe Ratio because of the favourably asymmetric distribution of returns.

Fig. 3.2 (above right) illustrates the rolling 3 year Sharpe & Morpho Ratios for the S&P 500. The S&P 500 Sharpe Ratio is unchanged, due to its normal distribution.

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Research Note

April 2020

At Morpho, we are interested in real-world results. Therefore, the following charts include comparatives to one of the best

performing alternative strategies that offers diversification to major market indices – CTAs (Commodity Trading Advisors

& Managed Futures). Additionally, we look at risk being defined as Drawdowns (our preference), not just volatility. Here

we use the CALMAR Ratio to illustrate risk-adjusted performance. The CALMAR Ratio measures annualised returns relative

to the Maximum Drawdown. Our strategies consistently demonstrate superior risk-adjusted performance across any

measure, in addition to superior absolute returns, while other strategies come & go on various measures.

4. And now for the News

Over the last year we haven’t just had our head down, developing absolute return strategies and undertaking quantitative

analysis that refines on established risk measurement practices. On the contrary, we’ve occasionally lifted our head to

look about and see what’s happening in the world around us. On a number of ocassions we even published our thoughts,

a selection of which follow:

Fig. 3.5 (left) illustrates the rolling 3 year Sharpe Ratio for

Morpho’s Uncorrelated Alpha strategy, comparing the standard

Sharpe Ratio formula with the Morpho Ratio (the Sharpe Ratio

adjusted to reflect the true distribution of returns rather than

presuming a normal distribution).

As per our other strategies, this adjustment improves on what is

already a healthy Sharpe Ratio because of the favourably

asymmetric distribution of returns.

We have included the standard Sharpe Ratio of the S&P 500 for

comparative purposes.

Fig. 3.6 (above left) illustrates the rolling 3 year Morpho Ratio for our three absolute return strategies compared to that of the S&P 500 and CTAs (i.e.

performance relative to risk with risk defined as volatility – adjusted for the true distribution characteristics of the underlying returns).

Fig. 3.7 (above right) illustrates the rolling 3 year CALMAR Ratio, comparing CTAs & the S&P 500 to our strategies (i.e. performance relative to risk

with risk defined as Drawdowns).

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Research Note

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Fig. 4.1 (left) We observed last May that the U.S. market continued to

show strength, deviating from other markets globally. This was

primarily due to U.S. corporates engaging in share buy-backs that

bolstered their share price & made relatively flat sales growth look

better than it actually was. However, as we noted, this is simply

financial engineering, which weakens a company’s Balance Sheet by

replacing equity with debt. As we concluded, there is no free lunch in

such practices, it merely takes future earnings and brings them into the

present, leaving the future with a greater degree of risk. The only

beneficiaries were corporate management who would have secured

that year’s bonus. Incentive systems need to be long-term in nature.

How many companies now wish they had the Balance Sheet strength

they possessed before they engaged in buy-backs?

Then again, perhaps corporate boards and management were counting

on Federal bailouts even back then?

Fig. 4.2 (right) Last October we highlighted that, due to convexity

(especially with yields approaching zero), asset managers were heading

into a world of higher risk and they were oblivious to the fact. We likened

them and their approach to investing to that of Custer’s last stand.

We added to that tweet, pointing out that Risk Parity as a strategy is

structurally impaired by those same risks.

2020 has thus far demonstrated that orthodox approaches to portfolio

management (e.g. 60-40 portfolios) have indeed reached their ‘use by’

date.

Likewise, what occurred in the Risk Parity space can only be described as

a cluster fuck of epic proportions. Thank goodness these ‘quant’ strategies

are managed by the smartest people in the room.*

* that was sarcasm

Fig. 4.3 (left) Throughout 2019 we posted this chart multiple times.

The yield curve kept telling people that a jump in volatility was on

the horizon. Still, everyone seemed surprised when it happened.

What this chart does show is that asset managers continue to operate

with short-term behaviours despite the fact that their business is the

management of assets over 20-40 year time horizons.

To those who are looking for that quick recovery the market is

currently pricing in, this chart might disabuse you of that notion. It

is telling you there are at least a couple more years of higher volatility

ahead.

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Research Note

April 2020

5. It pays to tinker

In addition to expressing our views on developments going on in markets and the world around us, we continued to make

new observations into the shape and structure of markets. This was all as a result of our endless tinkering and ceaseless

curiosity. The process of exploration and discovery is hard to beat, especially when it bears fruit.

One of the first insight-based models we developed was

adapted after we discovered that it was useful when

applied to CME Milk Futures. We published this

development in August of 2019. As we mentioned at the

time, when you have one genuine insight into the drivers

of markets, it leads to further insights because you now

know what you are looking for.

We subsequently had an opportunity to provide some of

our information to a global dairy cooperative. Part of the

information we provided was a forecast for the price of

CME Class III Milk Futures based on our proprietary

insights. It has proved to be fairly accurate.

Fig. 4.4 (right) This one is a couple of years old, but it was worth digging

out. We called “time” on holding exposure to credit late 2017. It was well

timed even though there was a temporary rally in credit spreads during

2019. It’s always better to be early rather than late when it comes to credit,

especially now that duration is lengthening in the ‘chase for yield’ and

that credit spreads increasingly show equity-like trading characteristics.

Yes, it was easy to anticipate the current crisis, though not the trigger, nor

the magnitude of the event that would begin the decline. All we knew was

that structural weaknesses were everywhere and that investing to achieve

an asymmetry in outcomes means taking these factors into consideration.

The jump in credit spreads in 2020 has rapidly erased years of marginal

gains, not to mention the process of rating downgrades (i.e. fallen angels)

has only just begun. Yet, asset managers will persist in their foolish games,

valuing activity over productivity – with other people’s money.

Fig. 5.1 (above) shows our discovery in relation to milk prices and how

insights into the shape and structure of markets in one area can open up other

areas that previously held a mystique because of the presumption that you

need esoteric knowledge.

Fig. 5.2 (right) shows our CME Class III Milk Futures price forecast of

August 2019 including the actual subsequent price path. So far, so good.

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Research Note

April 2020

When you have genuine insights into the drivers of markets, one of the key things it provides that other participants don’t

have is knowledge of what is important and what can be ignored. This reduces ‘noise’ and allows for clarity of thought,

whilst also elevating efficacy. By comparison, the market treats all information equally and lives by the creed that more is

better.

Take for example, another of our insight-based

discoveries. This is another of our unique creations,

having never seen anything like it in any way, shape or

form elsewhere. Something Dr John Hussman

acknowledged also. We discovered that the SKEW Index

has the potential to indicate significant market moves

when applied to the S&P 500. Maybe not a robust

indicator when used in isolation, but certainly another

useful and independent tool that can tell of the market’s

general condition.

This was just another indicator that confirmed all our

other (seemingly unrelated) indictors, which were

suggesting markets were setting up for a significant fall

– much of which is still yet to come.

6. We’ve been doing a spot of quanting

What are we currently working on? Well, we’ve gone back to have another look at our proprietary insight-based currency

model, which has had a few iterations. We think we may now have a meaningful platform from which to start building

something useful. It’s still a work in progress but we’ll let you have a sneak peek at how it’s shaping up thus far, which

includes a 1 year forecast horizon. As per our norm, it’s high-level and best used over a medium to long-term horizon. That’s

where the value is - if you have the discipline. The following chart [Fig. 6.1 (below)] shows it applied to the New Zealand Dollar.

Fig. 5.3 (right) shows our discovery that the CBOE SKEW Index has

the potential to indicate a general level of complacency amongst

market participants – i.e. the SKEW Index falls when the market is

no longer prepared to pay for tail risk protection. Ironically, this

means the market is ripe for a significant fall due to unhedged

investors then needing to chase the market down once a sell-off begins.

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Research Note

April 2020

7. Who was that masked man?

In this document we’ve given you a glimpse of Morpho Advisory and its

capabilities. Essentially we are creators of unique and proprietary

quantitative investments strategies with an emphasis on risk

management. We also have the capability to perform macroeconomic

research and market analysis, but those services have an abundance of

offerings elsewhere. We play to our strength, which is investment

strategies first, then with macro research and market analysis acting in

a supporting role. Ultimately, it is alternative and uncorrelated

investment strategies that are of greater worth, delivering the greater value-add than macroeconomic research and

market analysis.

Ironically, the preponderance of macroeconomic research houses and their clients aim to achieve what we have, but they

don’t offer anything as tangible as Morpho Advisory – merely hints

and suggestions. These other service providers produce

macroeconomic research and market analysis as a platform to

generate trade ideas and investment theses for their clients. We

have been able to bypass that traditional approach because we

have genuine insight into the structure of markets and their key

drivers. Our proposition is unique.

We are creators of unique and proprietary quantitative

investments strategies with an emphasis on risk management

We have genuine insight into the structure of markets and their key drivers. Our proposition is unique

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Research Note

April 2020

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Morpho Advisory

Unique Investment & Market Risk Solutions

Market Risk

Actively managed

Strategic Outlook

Multiple methods of application

Improved Measures of Risk

Meaningful, real-world application

Reduced Drawdowns

Real-world risk management

Reduced Volatility

Academic risk management

Higher Returns

The ultimate objective

Diversification

True benefits